The Future of Macroeconomic Policy: Nine Tentative Conclusions

The global economic crisis taught us to question our most cherished beliefs about the way we conduct macroeconomic policy. Earlier I had put forward some ideas to help guide conversations as we reexamine these beliefs. I was heartened by the wide online debate and the excellent discussions at a conference on post-crisis macroeconomic policy here in Washington last week. At the end of the conference, I organized my concluding thoughts around nine points. Let me go through them and see whether you agree or not.

1. We’ve entered a brave new world in the wake of the crisis; a very different world in terms of policy making and we just have to accept it.

2. In the age-old discussion of the relative roles of markets and the state, the pendulum has swung—at least a bit—toward the state.

3. The crisis made it clear that there are many distortions relevant for macroeconomics, many more than we thought earlier. We had ignored them, thinking they were the province of the micro-economist. As we integrate finance into macroeconomics, we’re discovering distortions within finance are macro-relevant. Agency theory—about incentives and behavior of entities or "agents"—is needed to explain how financial institutions work or do not work and how decisions are taken. Regulation and agency theory applied to regulators is important. Behavioral economics and its cousin, behavioral finance, are central as well.

4. Macroeconomic policy has many targets and many instruments (that is, the tools we use or variables to implement policy). There are many examples of this that were discussed at the conference, but here are two.

Monetary policy has to go beyond inflation stability, adding output and financial stability to the list of targets, and adding macro-prudential measures to the list of instruments.

Fiscal policy is more than just “G minus T” and an associated "multiplier" (the proportion or factor by which changes in government spending or taxes affect other parts of the economy). There are potentially dozens of instruments, each with their own dynamic effects that depend on the state of the economy and other policies. Bob Solow made the point that reducing discussions about fiscal policy to what is the right multiplier does not do service to the issue.

5. We may have many policy instruments, but we are not sure how to use them. In many cases, we are uncertain about what they are, how they should be used, and whether or not they will work. Again, many examples came up during the conference.

We don’t quite know what liquidity is, so a liquidity ratio is one more step into the unknown.

It was clear that some people believe capital controls work and some don’t.

Paul Romer made the point that, if you adopt a set of financial regulations and keep them unchanged, the markets will find a way around, and ten years later, you’ll have a financial crisis.

Mike Spence talked about the relative roles of self-regulation and regulation. Both are needed, but how we combine them is extremely unclear.

6. While these instruments are potentially useful, their use raises a number of political economy issues.

Some instruments are politically hard to use. Take cross border flows. Putting in place a multilateral regulatory structure will be very difficult. Even at the domestic level, some macro-prudential tools work by targeting specific sectors, sets of individuals, or firms, and may lead to strong political backlash by those groups.

Instruments can be misused. The more there are, the more the scope for misuse. It was clear from the discussion that a number of people think that, while there may be an economic case for capital controls, governments could use them instead of choosing the right macroeconomic policies. Dani Rodrik argued for using industrial policy to increase the production of tradables—goods or services that can be traded among countries—without getting a current account surplus. But in practice we know the limits of industrial policy, and they haven’t gone away.

7. Where do we go from here? In terms of research, the future is exciting. There are many topics on which we should work—namely macro issues with, as Joe Stiglitz said, the right micro foundations.

8. Things are harder on the policy front. Given we don’t quite know how to use the new tools and they can be misused, how should policymakers proceed? While we have a good sense of where we want to get to, a step-by-step approach is the way to do it.

Take inflation targeting. We can’t, from one day to the next, just give it up and have, say, a system with five targets and seven instruments. We don’t know how to do it and it would be unwise. We can, however, introduce gradually some macro-prudential tools, testing the water to see how they work.

Increasing the role of Special Drawing Rights in the international monetary system is another example. If we go in that direction, we can move slowly from, say, creating a market in private SDR bonds to exploring the possibility for the IMF to issue SDR bonds to the private sector and then, if feasible, issuing them to mobilize funds in times of systemic crisis.

Pragmatism is of the essence. This was a general theme that came up, for example, in Andrew Sheng’s discussion of the adaptive Chinese growth model. We have to try things carefully and see how they work.

9. We have to keep our hopes in check. There are going to be new crises that we have not anticipated. And, despite our best efforts, we could have old-type crises again. That was a theme in Adair Turner’s discussion of credit cycles. Can we, using agency theory and the right regulations, get rid of credit cycles? Or is it basic human nature that, no matter what we do, they will come back in some form?

I was asked whether the conference was "Washington Consensus 2". It was not intended to be and it was not. The conference was the beginning of a conversation, the beginning of an exploration, and we look forward to your contributions.

As I have commented previously here when regulators got involved in risk management and decided they would favor immensely what was perceived as having a low risk of default, even though those perceived as having a low risk of default already were much favored by the market, they shook ground zero, and got the markets moving towards the crisis.

In this respect, one of the most important issues to understand is how come such regulatory mistakes were made… and the answer is… because a very small group of persons managed to kidnap the debate and the regulatory process. A mutual admiration club arrangement is one of the most dangerous set ups as it can so easily degenerate into outright stupidity, and when this becomes leveraged on a global scale then there is no limit to what harm could be done. For instance, I ask what extra-natural forces allow a Basel Committee to apply basically the same regulatory paradigm that got the financial system into the crisis, and to still be able to regulate without defining a purpose for the banks it regulates.

Though I might also have said it before here on this blog let me repeat that if we leave our global efforts toward assuring environmental sustainability for the world in the hands of something alike the Basel Committee, then we´re toast even before the warming.

Accountability that requires the change of failed regulators and experts, is of key importance if we are going to stand a chance of a functioning global regulatory system… otherwise we are clearly better off letting a thousand regulatory systems bloom… or having none at all. If regulators are currently so successful in hiding their responsibility… can you imagine how much easier it will be for them to hide when they introduce the new reform complications, and which will guaranteed be even harder to gauge and understand?

[…] Blanchard, chief economist at IMF: The global economic crisis taught us to question our most cherished beliefs about the way we conduct macroeconomic policy. Earlier I had put forward some ideas to help guide conversations as we reexamine these beliefs. I was heartened by the wide online debate and the excellent discussions at a conference on post-crisis macroeconomic policy here in Washington last week. At the end of the conference, I organized my concluding thoughts around nine points. Let me go through them and see whether you agree or not. […]

Years ago while a professor at the Claremont Graduate School I filled in for a very famous macroeconomist and taught a graduate course in macroeconomics at a great American university. This was the final course for PhD students. They took their PhD exams immediately after the course. Most of them went on to become university faculty and Federal Reserve employees.

I found their knowledge of macroeconomics to be minimal. Indeed at the end of the class I commented to the department chairman that most of his PhD students in economics could not pass an undergraduate macro course at Claremont, let alone teach it. Each and every one of them was highly trained in statistics and mathematics. But they had not a clue as to how economic institutions and policies and the decisions of individuals affect the real world of prices, employment, and production.

It was a time of high interest rates and inflation so most of them were planning dissertations relating interest rates and the quantity of money to inflation. They were astonished to hear that higher general level of prices could be caused by many actions other than increases in the money supply and how the Federal Reserve’s Open Market Desk actually operated. The very real condition that the money supply might be increased to accomodate transactions at higher prices instead of causing the higher price levels distressed them (and subsequently several PhD committees).

I recall one young gentleman proving conclusively and scientifically that inflation was caused by increasing the money supply. He put up a marvelous equation to model the economy, plugged in an increase in the money supply, and voila a policy presented itself – reduce the monetary expanison to raise interest rates and the inflation would end! He and the class were appalled when I pointed out that the increases in the money supply and CPI over the years he presented tracked even better when the increases in price levels were associated with the ever increasing speed of airplanes over that period of time such that a better way to fight inflation appeared to simply require the Federal Reserve to order planes to fly slower.

The world is complex and filled with black swans. At best models are overly simplistic and only apply until they don’t apply. What counts when advocating a policy is an understanding of both the basic relationships between spending and production AND the complexities and institutional responses of the real world. It is my observation that most so-call macroeconomists emphasize the former and all but ignore the latter.

[…] And he has every right to. Although Krugman gave some very good explanations, and that unemployment is not getting worse (it is just not getting better), I agree with Romer that the silence won’t help our current economic situation and us moving toward Blanchard’s Brave New World. […]

Mr Blanchard:
One fact which is clear to me is that when the people that manage financial institutions are personally at risk from the failure of their institutions (banks, insurance companies, etc.), then it’s much more likely that those same institutions will take decisions which do not place whole societies at risk–even if the development of credit and risk-taking may be much slower than otherwise. One thing I’ve learned, or re-learned from the financial crisis is that our financial systems must make clear where the buck stops, and we should try to marry the economic rents or excess returns with the entities or individuals who are taking the risks (often the taxpayer). Warren Buffett received an annual interest payment of 10% from Goldman Sachs for his investment in them post-crash. Where is the 10% annual income return for the taxpayers who supported CITI, RBS, and the others? The separation of economic rents from the carrying of risks is at the heart of our problems.

[…] be uncomfortable in contrast to the earlier sense of certainty). There will be mistakes. And, as Olivier Blanchard said in his excellent summary, we will proceed step-by-step, evaluating the impacts of policy choices […]

[…] global financial crisis gave economists pause for thought about what should be the future of macroeconomic policy. We have devoted much of our thinking to this issue these past three years, including how the many […]

There are two issues: what the term “crisis” denotes, and how you assess the accuracy/utility of a set of projections. I’m not remotely expert enough to talk about how the assessment should be done for “crisis” projections (or whether how it’s currently being done is adequate); I was just pointing out that these terms when used by “experts” have the meanings that “experts”, rather than colloquial usage, define them to have, in the same way that the term “function” means different things to mathematicians, to computer programmers and people in general.